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Business Credit: Understanding Bad Debt and Federal Income Taxes

n today’s economic climate, business credit continues to affect the financial strength of businesses across the country. In our previous newsletter, we outlined basic business credit advice. In this issue, we address federal income tax issues that lurk behind any debt restructuring or debt forgiveness that a company may arrange with one or more of its customers.

Introduction - The current poor business conditions have increasingly led to customers having problems paying and have raised the need for businesses to work with customers to reduce outstanding debts and modify obligations. One popular option is loan workouts: they give customers breathing room, and they help the company improve its odds of receiving some repayment. When the receivables cannot be collected, however, a business should consider declaring it “bad debt.” Such a decision carries consequences, and there are several implications—for businesses and customers—worth consideration.

Bad Debt Basics - Bad debt is the portion of a business’s receivables that it believes it can no longer collect. A company can choose to cancel bad debt by 1) reducing the principal or 2) accepting property worth less than the full amount of the debt. If a company chooses to cancel its bad debt, it is entitled to a deduction on its federal income taxes.

The deduction depends on whether the debt is business debt or nonbusiness debt. Bad debt belonging to a nonbusiness is deductable as a short-term capital loss, while bad debt belonging to a business is deductable from ordinary income. This is an important distinction as a deduction from ordinary income can be taken in the full amount of the deduction, while a short-term capital loss may only offset capital gains and may not be able to be taken in full.

To claim a deduction for bad debt in a given tax year, the company must establish that it had no hope to collect the debt. If, at the time of the restructure, the company receives something in exchange for the debt, like a modified debt instrument on the underlying collateral, the company will recognize gain or loss equal to the difference between the value of what was received and the balance of the bad debt. (If the deducted bad debt is collected, the portion of the bad debt that is collected should be included in the lender’s income for the year in which it is recovered.)

Implications for Companies – Customers needing to restructure their debt obligations typically need their interest and principal payments to better match their cash flows. However, without careful planning, the benefits of debt restructuring can be lost, by triggering cancellation of indebtedness income (“COD”). COD is problematic because troubled customers frequently lack the cash to pay the income tax on COD.

COD generates taxable income under federal income tax law because the release of the obligation to repay the whole or a portion of the indebtedness is equal to an accession to wealth. For companies to increase their chances of being repaid on restructured debt, it is important that they understand the basic triggers of COD, and work with the available exceptions to produce better tax results.

Implications for Customers - Customers have several helpful exemptions from COD when they do not have enough net operating losses to shelter COD. There also are statutory exclusions from COD that come with a trade-off. This means the customer will not pay taxes on the COD amount in the taxable year, but must instead recognize a portion of the excluded amount when selling assets. Such exemptions and exclusions include:

  • Purchase Price Reduction Exception – If the customer is not in bankruptcy or otherwise insolvent, then it is treated as having paid a lesser amount for the product(s), and the business is treated as having sold the product(s) for a lesser amount.
  • Insolvency Exclusion – Income does not include an amount that otherwise would constitute COD if the discharge occurs while the borrower is insolvent. For tax purposes, insolvency means there is an excess of liabilities over the fair market value of assets.
  • Bankruptcy Exclusion – A separate exclusion exists for when a discharge occurs while the customer is in bankruptcy. The bankruptcy exclusion is broader than the insolvency exclusion since the bankruptcy exclusion applies even if the debt discharge makes the customer solvent.

Different Tax Treatment For Exchange Or Sale Of The Bad Debt – There is a critical tax difference between a pure debt restructuring and a restructuring which includes asset or entity interest transfers. The former can result in COD treated as ordinary income, while the latter may generate capital gains. This difference may not matter to a borrower structured as a C-corporation, because C-corporations face no difference in tax rates on capital gains versus tax rates on ordinary income. However, for a partnership, an S-corporation, or individual customers, utilizing assets or entity interest transfers may generate long-term capital gains income which may only be taxed at the current 15% long-term capital gains rate. This possibility of converting what might otherwise be COD taxable at a 35% federal rate into long-term capital gains taxable at a 15% rate creates an important planning opportunity. Thus, in any debt restructuring, it may be wise to consider the tax consequences of a foreclosure, the issuance of a deed in lieu of foreclosure, or a sale to a third party.

Conclusion – There are few financial transactions that do not have tax consequences. Companies need to be mindful of such consequences when restructuring debt so they do not inadvertently create large income tax liability for customers, which could further inhibit repayment. Likewise, customers in the process of restructuring their debt need to be wary, and should even consider retaining qualified tax advisors to carefully analyze their situation and to see which type of restructure might best suit their needs. The ordinary income nature of COD, the possibility of generating capital gains income through a sale transaction, and the complexity of applying COD definitional exceptions and statutory exclusions to various business organizations are all considerations that should be kept in mind when restructuring debt.

If you have questions, please contact Scott Leisz, 317.686.5215 or sleisz@binghammchale.com .

  • Partner

    Scott has over 30 years of experience in litigation and trial practice. He concentrates his practice in the area of business litigation in federal and state trial and appellate courts, including: corporate governance and ...

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